Description

TL; DR: I think Twitter is the best merger arb situation we'll see in modern markets (i.e. since the dawn of the internet / when people could buy merger stocks before the merger announcement had widely disseminated thanks to the limitations of fax machines). Twitter is as close to a lock to win in court as I think it gets. 95%+ chance the deal closes on terms or with a slight haircut to give Twitter deal certainty / speed the process up. <5% chance Elon goes to court and pulls a rabbit out of his hat and walks away. I post this on VIC now because I think current prices present an insane risk / reward, I think the market has underresponded to some recent news flow, and because I'd love continued feedback / discussion on a live deal that is changing literally tweet by tweet.

Full write up below

Twitter was written up on this site on Feb. 14 at $35.67/share. I highlight that because

1. I know it was written up less than 6 months ago; I'm fully up on my membership idea obligations so don't stone me for re-posting within six months!
2. The idea / event has changed just a little bit in the ~3.5 months since write up

For those living under a rock, a few weeks after that TWTR write up, Elon Musk started buying TWTR on the open market. This eventually lead to him filing a 13-D on the company, almost joining the board, and then a shotgun sales process that saw Elon agree to buy TWTR for $54.20/share in late April (the process included countless securities violations on Musk's side if you're in to that type of thing!).

Basically as the ink was drying on the deal, Elon placed the deal "on hold." He alleged the issue was reps and warranties violations on Twitter's end related to their bot problem, but I (and most observers) would argue the real reason he is on "hold" is due to his buyer's remorse as he's clearly over paying for Twitter in today's market (as one way to show this, TWTR is down 12% on the year, while SNAP is down over 50% and the QQQ is down ~25%; without Elon, I'd guess TWTR's stock is ~$20/share today versus the current price of ~$39. Reasonable people can argue if the downside w/o a deal is $25, $20, or $15, but no one thinks the stock would have anything close to a 3 handle without Elon's bid). Let's say the downside is $20/share. At today's price of ~$39, the market would be pricing in ~56% chance of the deal closing on deal terms (62% if you change the downside to $15). That seems much too low; as I'll show below, I think Twitter would be a near lock to win in court. Elon's case to get out of the Twitter deal is laughingly weak, and much stronger cases have gone to court on similar claims and lost before.

The problem for Elon is that there is no such thing as putting a deal on hold. Elon signed a contract with Twitter, and in his rush to buy Twitter he offered a "seller friendly" contract (his words, see p. 51 of the proxy) that gives Twitter the right to pursue specific performance if Elon doesn't uphold his obligations. The contract Twitter signed is indeed quite seller friendly, and if Elon continues to be Elon I think he will be taken to court and forced to close on the Twitter deal on terms.

A very handsome blogger has both written about and podcasted on what's happening with Twitter and why Elon will be forced to close recently (I'd encourage you to read / listen to those for extra background, though I'll hit many of the same points in this post), which begs the question of why I'm chosing now to put the idea on VIC.

The simple answer to that questions is that, when deal was announced, there were 3.5 main risks

1. Financing
2. Regulatory
3. Elon being Elon and deciding on a whim he wanted to get out of this contract
   • The .5 risk belongs here: Elon being Elon and the board getting rolled over in response

To me, by far the biggest risk to this deal actually breaking was #1 (financing). Part of Elon's cash to buy Twitter was coming from a margin loan on his Tesla stock, and the easiest way for Elon to walk would be Tesla's stock tanking and Elon using the margin loan blowing up to walk away. Since the deal was signed, Elon has done various moves that have reduced his reliance on the margin loan, and last night Elon filed a 13-D that announced he had fully replaced the margin loan for the deal wih equity (in addition, the filing disclosed he was in continued talks to have Jack Dorsey roll his equity stake into the private company). With the margin loan settled, financing risk is completely off the table.

The second largest deal risk was the "0.5" risk. Of course Elon was going to be Elon, but would the board let him get away with it? If Elon pulled something strange, maybe the board looked at a looming legal battle to close the deal and said "not worth the headache", took a $1b break fee instead of specific performance, and walked. I think we can largely remove that risk as well; as part of filing the prelim proxy, the company released a statement that said they are "committed to completing the transaction on the agreed price and terms as promptly as practicable." Might seem an innocuous statement on the face of it, but companies generally quietly file their proxies. I cannot think of a single time a company has put out a similar statement alongside the proxy; combine that statement with statements the board has given news outlets, and I think there's no question the board will pursue a legal case if Musk tries to walk. Musk is not walking for a simple $1B break fee (as some people have speculated he can); if he tries to walk, the board is suing him for specific performance and we are going to court.

So why am I writing this up now? Over the past ten days, the two largest risks to the deal have melted away. At this point, we are stuck with regulatory risk and Elon being Elon risk.

Regulatory risk here is simple. Elon Musk is buying Twitter in his individual capacity. There is no regulatory case for blocking Elon from buying Twitter (in fact, there would be no regulatory risk for any of Elon's companies trying to buy Twitter, though the thought of Tesla announcing a strategic merger with Twitter does make me laugh!). At this point, the deal is only subject to HSR and UK CMA approval (I might be missing a small country or two in there, but nothing meaningful and everyone will fall in line with each other). Yes, Elon could walk if regulatory tried to block him, but, for all sorts of reasons, I doubt the DOJ is willing to tarnish their reputation by trying a novel block on the richest person in the world making an acquisition (republicans would go ape shit, every major donor would go ballistic because they'd worry about the precedent the block sets for their future acquisitions, I generally think the DOJ tries to follow the law, etc). Also, worth noting Elon has security clearance given his involvement in SpaceX; that would probably only matter if CFIUS was required (it shouldn't be), but it would add extra hair to a DOJ block (this man can be trusted with state secrets, but you're saying he can't buy Twitter because he's too rich?).

So a regulatory block is extremely low likelihood; call it 1%, though I think even that might be overstating it. Again, we've never had a deal investigated because the buyer was too rich, and the precedent would be awful (plus the DOJ would lose in court, though I suspect Elon would happily use the DOJ's attempted block to walk and we'd never hit the court steps).

That leaves you with Elon being Elon risk, and that's what the market is dealing with right now.

Twitter has a "seller friendly" contract to sell to Elon, but Elon has cold feet and is trying to get out of the deal. He is doing this by alleging that Twitter has more bots than they claimed, and thus breached their "reps and warranties" he relied upon in buying them in breach ofsection 4.6 of the merger contract. You can see this in a more clearly in recent tweet about a $150m fine Twitter agreed to pay for a years old investigation where he asked "If Twitter was not truthful here, what else is not true? This is very concerning news." Elon's clearly trying to set up for a suit where he claims Twitter lied in their financial statements, and thus he can get out of the deal without penalty.

That argument is going to face a very high bar, and it will near certainly come up short. To start, Elon will hold the burden of proof here. He'll need to get a judge to agree that not only was TWTR wrong on their bot estimate, but that he relied on TWTR's bot numbers in his assesment of TWTR's value, and that TWTR was so materially wrong in their representation of the bot number that Elon's view of TWTR's value was way off. A judge will almost certainly laugh that argument out of court.

Why?

To start, for years, Twitter has been clear that their mDAU numbers were estimates (from their 2021 10-k "The numbers of mDAU presented in this Annual Report on Form 10-K are based on internal company data. While these numbers are based on what we believe to be reasonable estimates for the applicable period of measurement, there are inherent challenges in measuring usage and engagement across our large number of total accounts around the world. Furthermore, our metrics may be impacted by our information quality efforts, which are our overall efforts to reduce malicious activity on the service, inclusive of spam, malicious automation, and fake accounts. For example, there are a number of false or spam accounts in existence on our platform. We have performed an internal review of a sample of accounts and estimate that the average of false or spam accounts during the fourth quarter of 2021 represented fewer than 5% of our mDAU during the quarter. The false or spam accounts for a period represents the average of false or spam accounts in the samples during each monthly analysis period during the quarter. In making this determination, we applied significant judgment, so our estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than we have estimated. We are continually seeking to improve our ability to estimate the total number of spam accounts and eliminate them from the calculation of our mDAU, and have made improvements in our spam detection capabilities that have resulted in the suspension of a large number of spam, malicious automation, and fake accounts. We intend to continue to make such improvements. After we determine an account is spam, malicious automation, or fake, we stop counting it in our mDAU, or other related metrics. We also treat multiple accounts held by a single person or organization as multiple mDAU because we permit people and organizations to have more than one account. Additionally, some accounts used by organizations are used by many people within the organization. As such, the calculations of our mDAU may not accurately reflect the actual number of people or organizations using our platform."), and Elon clearly knew bots on Twitter were an issue (they were mentioned in the deal press release!). Elon had every right to due diligence TWTR's bot number before agreeing to the deal, but he waived DD in his rush to get a deal done. As one lawyer said, being aware of a problem while waiving due diligene on it is the exact type of behavior that makes claiming an MAE difficult.

Second, even if you ignore that combo, it's tough to claim that bots being higher than TWTR's estimates has a material effect on TWTR's finances. TWTR largely relies on advertising; in order for the bot number being higher to be material, you'd need to prove that advertisers were getting defrauded by Twitter. That's a very tough bar; advertisers tend to track their ROI quite closely, and (to the extent bots are an issue) they are almost certainly adjusting for bots when they bid their ad budgets. If advertisers understand bots and adjust when they bid, then it's extremely difficult to argue the bot issue harms TWTR's value (in order for the bots to harm TWTR's value, you'd have to argue that for years advertisers have been spending too much on ads because they were decieved by the bots. That clearly can't be true; advertisers monitor ROI very closely, and if the bots were a problem advertisers would have pulled back and/or adjusted ad spend on TWTR years ago).

Third, and this goes a little hand in hand with #2, the bar for something rising the level of materiality in breaking a contract is very high. The best case here is probably Boston Scientific versus Channel Medsystems. After Boston agreed to acquire Channel, they discovered that a VP was falsifing expense reports and had falsified FDA docs. Boston tried to pull out of the mergerand Channel sued. The court eventually found that while the false reports did represent a breach of reps, it did not rise to the level of materiallity that would allow them to pull out of the contract. So the judge ruled in favor of Channel, and BSX settled the case for a huge payout (they don't give the specific number, but p. 52 of their 10-K suggests they paid out almost the full value of the contract).

There are not a ton of other cases we can discuss simply because there aren't many cases of companies trying to take a breach of reps / material claim court to court. Precedents that people have tossed around is Tyson / IBP from 2001, Huntsman / Hexion from 2008, Kohlberg / Decopac during COVID, Hillrom / Bardy in 2021, and Akorn / Fresnius in 2018. The only one where the buyer successfully walked was Akorn / Fresnius, and it took "blatant fraud at the very top level" with Akron "repeatedly and consciously" violating FDA requirements for Fresnius to walk. I'd argue every case had a better claim to break than Elon has with Twitter, and each other case lost. I'd also note the Abbott / Alere deal as a good precedent; the full thing was summed up here, but to shorten the story Alere got hit with a DOJ subpeona and had their business fall off a cliff after the deal was signed, and Abbott went into a mediation and decided getting a small haircut (from $56/share to $51/share) was better than risking losing in court and paying full price. Alere was going through so many issues that their standalone value was probably ~half what Alere ended up paying, so for Abbott to get such a small haircut speaks to how high the bar for these claims is.

The best precedent for what will happen with TWTR / Elon is probably TIF / LVMH. LVMH got cold feet buying TIF after COVID hit and tried to get out of their contract; in the end, LVMH realized they were going to lose and managed to get a very small price cut in exchange for deal certainty. 

Anyway, the bottom line is that the history of the types of claims Elon is making going to court and winning is awful, and Elon's claim is materially worse than any claim that has tried to get out before. Elon is a wild man, and he's going to try to make things as uncomfortable as possible for the Twitter board to get them to recut the deal or let him off the hook. But Twitter's position is strong; if they recut, they can do so from a position of strength and give a token recut in exchange for absolute certainty of deal close. And if they go to court, they will almost certainly win.

I'm happy to engage more in the comments, but I'm rambling a little and I think readers can probably get where I'm driving by now: I doubt this comes to a court case; Elon will rattle a bunch of cages, but ultimately he will close on terms (and, if it does come to a court case, it will be uncomfortable for Elon and he will get destroyed).

I did want to highlight six points that I think have been under mentioned / discussed before wrapping up.

1. TWTR's proxy included forecasts on p. 81. 2023E EBITDA is ~$2.7B; that's miles ahead of consensus (BB shows consensus at ~$1.8B). I doubt anyone trusts management forecasts, but figured it was worth noting. They're projections also include unlevered free cash flow estimates with and without stock-comp; by 2025, they're projecting $2.4B in unlevered FCF and $1.1B of unlevered FCF net of stock comp. TWTR's EV is ~$30B at current prices; again, I don't think anyone trusts the projections, but they're miles ahead of what analysts and investors were forecasting and you could probably make a value case for TWTR if you give them some benefit of the doubt on those forecasts.
2. Elon is in breach of the merger contract basically every time he tweets (p. 51 forbids him from disparging Twitter). In the grand scheme of him trying to break a ~$45B merger contract because of cold feet, that's nothing. But, if it comes to a court case, I think the continued breaches are really going to bite him. All of his tweets were in breach of contract and speak to his state of mind in trying to get out of the contract, and they're unlikely to generate any sympathy from a judge. Again, just because he's tweeting wildly doesn't mean he losses the case, but combined with the other facts in the potential case and the high bar for his claims, and he's just really not doing himself any favors.
3. The "no margin loan" 13-D last night also mentioned discussions with Jack Dorsey about Dorsey rolling his equity stake in Twitter. Could be nothing, but if Elon tries to get out of this contract Twitter will be entitled to discovery. And the discovery on Elon's discussions with Dorsey about rolling his stake while Elon is disparaging Twitter will get very interesting and could destroy Elon's own case that the bots are material.
4. Speaking of discovery, probably the only path the Twitter losing this case is if Elon can prove that Twitter not only underestimated their "bot problem" but that they knowingly underestimated the bot problem. In this regard, there are two great pieces of new for Twitter. First, the Boston / Channel case (and the ALR / ABT case) show that mid-level people committing fraud is not, in itself, a reason for a reps and warranties breach. So for Elon to be successful here, he probably needs to prove upper management knew of the bot problem and intentionally decieved investors. Which brings us to point two: Jack Dorsey was Twitter's CEO until November 2021, and the bot problem would have had to have been going on for years. Both Elon's 13-D and the proxy show Elon has talked to Jack about the Twitter deal constantly; for Elon to have been talking this frequently and then allege that top management was intentionally misstating bot figures in a materially way while Elon also talks to the top management about rolling their equity and why he should take Twitter private..... well, that's quite the bank shot!
5. It's worth noting that Twitter filed their prelim proxy on May 17th, roughly 3 weeks after the merger was announced. I've never seen a prelim filed that quickly, particularly for a deal this large. If I was the board, my goal here would be to be complete quiet, get every condition (shareholder and regulatory approval) met without raising a fuss, and then go to Elon and say "all conditions completed; wire us the money now or we'll see you in court." Everything the board is doing, from the speed of the proxy to how quiet / buttoned up they have been suggests this is the path they're pursuing.
6. The most common feedback I'll get against going long Twitter is "somehow Elon gets out of everything." I get that, but the market is pricing in ~60% odds of Twitter winning a court case for a deal that has basically no other way to break now that financing is actually secured. If this was any other buyer, the market would have, at worse, 80% odds priced in that the deal goes through. The market is giving a very wide "Elon always wins" discount currently, and I think Delaware courts will not be kind to Elon if this hits the courtroom. Courts are playing the long game, and I don't think they'll be eager to give deference to a billionaire who got cold feet and frequently broke a merger contract (through his tweets) in an effort to get out of it. Setting that precedent probably wouldn't be great for Delaware as a whole (a state whose largest industry is having an effecient and rational corporate legal system). All that said.... things will probably get volatile here. I've been keeping the position undersized versus how good I think it is just so I've got some dry powder to buy on the day Elon tweets "Twitter is a fraud so I'm breaking the deal and putting all my assets in dogecoin where they'll never be able to touch them!" (obviously not investing advice; just how i'm approaching sizing. Do your own work!)

Catalyst

Elon closes on terms